Thursday, July 16, 2015

The Bank of Canada Stumped?

Stephen Poloz is refusing to call it a recession, but the Bank of Canada Governor says the country needs another jolt of interest rate relief as the economy shrinks and exports stall.

The central bank lowered its trend-setting overnight rate a quarter percentage point Wednesday to 0.50 per cent – the second rate cut in six months that sent the Canadian dollar tumbling and prompted three major banks to lower borrowing rates.

The central bank also slashed its forecast for the Canadian economy, acknowledging for the first time that gross domestic product will likely decline in both the first and second quarters. And the bank said growth for the full year will reach just 1.1 per cent, a major downgrade from the nearly 2 per cent it was predicting just three months ago.

Back-to-back quarters is the traditional litmus test of whether an economy is in recession. But Mr. Poloz said it will take months for experts to make that determination, carefully avoiding using the R-word.

“I’m not going to engage in the debate over what we actually call this,” Mr. Poloz told reporters in Ottawa. “No doubt, we have worked our way through a mild contraction.”

The Canadian dollar lost more than a cent to end at 77.40 cents (U.S.) in the wake of the decision – its lowest level since the depth of the recession in 2009. Toronto-Dominion Bank reacted with a reduction in its prime rate Wednesday by a 10th of a percentage point to 2.75 per cent and Royal Bank of Canada and Bank of Montreal reduced theirs by 0.15 points to 2.70 per cent from 2.85 per cent, effective July 16, 2015.

The Bank of Canada acknowledged that lower rates could exacerbate record household debt levels and add fuel to overheated housing markets in cities such as Toronto and Vancouver. But Mr. Poloz said it’s a risk worth taking given the shock facing the economy.

“Canada’s economy is undergoing a significant and complex adjustment,” the bank said in a statement accompanying its rate decision. “Additional monetary stimulus is required at this time to help return the economy to full capacity and inflation sustainably to target.”The latest rate cut marks a sudden about-face by Mr. Poloz, who has repeatedly insisted that the economic hit from the oil price collapse would be quickly offset by surging non-oil exports, such as car parts, lumber and services. He had characterized his earlier January rate cut as “insurance.”

Six months later, the export rebound remains elusive, in spite of a much cheaper Canadian dollar. Mr. Poloz said the bank anticipated that cheaper crude prices would take a bite out of exports, but the failure of non-energy exports to pick up as the dollar falls is a “puzzle” that the bank is now hard at work trying to sort out.

Among other reasons for the rate cut, Mr. Poloz cited a deeper-than-expected plunge in Western Canadian oil patch investments and weaker growth in China, which is depressing other commodities, including metals.

“The facts have changed, quite quickly actually, in the last two to three months,” Mr. Poloz told reporters. “One of the big shocks in this outlook is the downgrade of investment intentions by the companies in the oil patch.”

There is another reason the Bank of Canada may want lower interest rates, economists say. A growing gap between rates in Canada and U.S., where the U.S. Federal Reserve is poised to start increasing its benchmark, could help push the Canadian dollar even lower in the coming months, making exports more competitive in foreign markets and encouraging Canadians to spend more of their cash at home.

Part of the puzzle why non-oil exports have been slow to react to the lower dollar is that currencies are just one of many factors that companies consider before making investments, pointed out Ben Homsy, a fixed-income analyst at Vancouver-based Leith Wheeler Investment Funds.

“Short-term weakness in a currency doesn’t always spur a manufacturing firm to build a plant here in Canada and to start employing people,” Mr. Homsy said. “You need a sustained period of currency weakness.”

Other experts speculated the bank may have opted to cut rates now, rather than waiting until its next scheduled announcement Sept. 9, to avoid being seen as meddling in the coming federal election.

Canada’s fundamental problem is that it now has a distinctly two-track economy – one faltering badly because it’s tied to oil and other commodities, and another growing modestly due to “solid” household spending and an improving U.S. economy.

A massive plunge in business investment – down 16 per cent in the first quarter – has become a deadweight on the economy. The energy sector makes up less than 20 per cent of the economy, but it drives an oversized share of business investment. The bank now says it expects investment in Canada’s oil patch to plummet close to 40 per cent this year, significantly worse than the 30 per cent it initially thought, as long-term investments in the oil sands are delayed or put on hold until the price of crude recovers.

How low can the loonie go? I wouldn't be surprised if over the next two years it falls below 65 cents U.S., especially if another financial crisis hits the world and global deflation sets in sending oil prices to record lows. In that nightmare scenario, the loonie can even sink below 60 cents U.S. or worse.

Steve Poloz isn't a dumb guy. Far from it. In my opinion, he's one of the sharpest central bankers in the world and has tremendous experience which many others lack. I worked with him at BCA Research when he was writing on international markets.

Importantly, Poloz understands the global economy better than most economists and I think he's very worried about global deflation and how debt deflation will pummel the Canadian economy. Unlike me, however, he has a politically sensitive position and can't blurt out what really worries him on a personal blog.

As far as why Canadian exports are weaker than expected, stumping the central bank, I have an explanation for that too. I don't think the U.S. economy is as strong as many economists claim. Sure, relative to the rest of the world, it's doing better which is one reason the greenback keeps surging higher, but the breadth and depth of this U.S. recovery is lacking as witnessed by the labor force participation rate which sunk to its lowest level in four decades as structural long term unemployment keeps rising.

There are other reasons why Canadian exports are languishing. Canada's productivity isn't competitive, especially relative to the U.S., and as I wrote in my somber Canada Day comment, the effects of a lower loonie aren't going to boost manufacturing as much as in previous cycles:

The lower loonie will help boost tourism and manufacturing, but lower energy prices in the U.S. typically mean that manufacturing in Canada isn't as competitive as it once was. The shale energy revolution in the U.S. is very bad for Canadian manufacturing activity, which has slowly but surely been declining over the years.

Employment in the financial services industry and construction in particular will get hit hard. Already banks are in cost-cutting mode, shedding many employees, fearing the worst lies ahead. It will get worse for both these sectors.

The sad reality is that too many economists got it wrong and continue to think that the Canadian economy will escape a serious crisis. It won't, things will get much worse over the next few years.

Sober Look recently posted an excellent comment on Canada's "atrocious" turn of events, stating "the Canadian economy is no longer the darling of the G7, now that it is experiencing recessionary conditions."

Another economist/ global macro portfolio manager who has been nailing it is Ted Carmichael. On his global macro blog, he writes that the Bank of Canada rate cut was appropriate and he rightly criticizes forecasters for missing it again with their wildly optimistic global growth forecasts.

As far as Canadian equities, they got a boost from the Bank of Canada's rate cut decision but I would use any pop to short them or lighten positions. Lower energy prices and a material slowdown in the Canadian economy will hit energy companies and bank stocks hard. Apart from energy, commodities and financials, there's not much else going on in Canadian equities. That's one reason why I've been solely investing/ trading U.S. stocks post-2008 crisis (apart from my short loonie call, I've been only trading/ investing in U.S. biotech shares over last two years).

What about Canada's housing bubble? The Bank of Canada acknowledged that lower rates could exacerbate record household debt levels and add fuel to overheated housing markets in cities such as Toronto and Vancouver but Poloz said it’s a risk worth taking given the shock facing the economy.

He may be right but the truth is Canada's housing market is a dead man walking. I know, "rich Chinese, Russians and Syrians" are all looking to come to Canada and buy a house here but I think there are better places to settle down and I'm worried that once deflation sets in and unemployment soars, there will be a prolonged and significant slowdown in the Canadian housing market unlike anything we've ever seen.

Notice I'm not talking about higher rates. Canadian real estate doom and gloomer Garth Turner discusses a tale of two nations where he states his usual nonsense that the Fed is getting ready to jack up rates and this will spell the death knell for Canada's housing market. Poor Garth, he's blocked me from posting comments on his blog because he simply can't understand, it's all about debt deflation stupid!, and that is the transmission mechanism which will clobber Canadian real estate in the next few years as unemployment soars to record levels.

Below, for all of you who think the Fed is going to raise rates this year, take the time to listen to Jeff Gundlach, DoubleLine Capital CEO and the new bond king, as he reacts to statements made by Federal Reserve Chair Janet Yellen. "I don't see how Fed can tighten this year, says Gundlach.

And speaking at the Delivering Alpha conference Wednesday, Gregory Beard, global head of natural resources at Apollo Global Management, said oil prices will stay low for the immediate future.

I think that's a fairly optimistic forecast. Canadians better hope the reflationistas are right but I'm increasingly worried that they're not and our economy will get clobbered over the next few years, especially if another financial crisis pummels markets and global deflation sets in.

Feedback: Tony Deutsch, retired professor of economics from McGill University shared this with me after reading this comment:

Leo, I see the rate cut as a ‘we are doing something about it” signal by Ottawa. Please note that the Governor of the Bank of Canada, unlike his counterparts in the US and in the UK is formally subject to the government since the Diefenbaker vs. Coyne conflict. Unlike you, I do not see a global economic collapse on the horizon, but do suspect that a significant portion of Canada’s non-commodity exports are priced internationally in US $, thus in the short run there will be no great export volume increase in response to the fall in the price of Can$. For the same reason, the Canadian consumer will soon feel the fall in his purchasing power, from his breakfast orange juice to the price in his Vietnamese sewn shirts.

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